This article was written by Sean Hannon, CFA, CFP, of

One powerful lesson we can take from this bear market is the need to hedge risks. We have seen cheap stocks become cheaper as investors deleverage and shun risky assets. With others fleeing the markets en masse, astute investors with the willingness to provide liquidity to the market can buy shares at low valuations.

While bottom-fishing, we must also remember that markets can stay irrational longer than we can remain solvent. Therefore, look to hedge your positions in the most advantageous manner you can find. Typically, investors buying stocks could pay a small premium for a put option to insure against large losses. With VIX trading above 60, option hedges have become uneconomical. Knowing this, I look toward pair trades as a means of hedging my risk.

The purest pair trade is one where you are long and short two stocks in the same industry. Doing so allows you to eliminate factors that would affect the industry and trade the relative valuation of each competitor. I often look to be long the stock that is either more reasonably valued or is the better operating company. Conversely, I will short the company that is overvalued or has an inferior operating business.

Within this framework you can often find trades where one of the two criteria is met. On rare occasions you are presented an opportunity to own the stronger company at a low valuation and be short the weaker company at a high valuation. Today we are presented that opportunity.

I find the trade in the airline industry. While I acknowledge that the airline industry has large structural problems and little earnings visibility in the current economic environment, I do not want to make a statement on absolute valuation. Instead I will focus on relative valuation and the opportunities presented.

For the long side, I recommend buying


(CAL) - Get Report

. CAL is among the strongest of the airlines and has tended to trade at a premium valuation to its competitors. On a trailing four-quarter basis, CAL has lost $.3 million on sales of $15.1 billion. Looking at their balance sheet, debt is high, with total debt nearing 76 times total capital. While the inability to earn a profit on $15 billion of sales and a large debt level would scare most away, looking at certain competitors justifies the pair trade.

On the short side,

United Airlines


has lost nearly $4 billion on sales of $20.5 billion over the past four quarters. Looking at the balance sheet, UAUA's debt is approaching 119 times total capital. If we thought CAL's results and balance sheet were poor, UAUA's are frightening.

Given the profitability and leverage of each airline, I could recommend shorting UAUA and buying CAL. However, investors are offered one additional benefit. For the past six months, CAL has traded at an average premium to UAUA of 158% with a median premium of 155%. Currently the premium is 108%. The last two times the relative valuation was this low, CAL's average premium was restored in 13 and 18 trading days, respectively. This quick mean reversion translated into 30% gain in a few weeks' time.

This market has been unforgiving over the last two months as indiscriminate selling has altered the way that investors behave. Within this chaos, opportunity exists. Being long CAL and short UAUA allows an investor to reduce risk to the overall economic environment while being long a superior company at low relative valuations and short a weak competitor at high relative valuations. Whether it is the economic backdrop or company specific news, I expect CAL's longtime premium to UAUA to resume and deliver quick, meaningful profits to opportunistic investors.

At the time of publication, Sean Hannon was long neither CAL or UAUA.